A Short History of Folly

Image credit: “One investment that is Never too high to buy,” advertisement by American Trustee Share Corporation from Forbes Magazine (1928), author’s collection

Researching my upcoming weekly column for The Wall Street Journal reminded me of the mania for investment trusts in the late 1920s, which I had first written about more than 20 years ago. Here’s a look back at that early article, which — despite its ludicrously wrong call on Berkshire Hathaway toward the end — still isn’t a bad survey of the long history of fads and crazes in the financial markets.

“A Short History of Folly”

Forbes Magazine, Aug. 29, 1994

In the late 1880s new British investment trusts, the forerunners of today’s mutual funds, were being coined every other week. Where were they putting a lot of their money? In emerging markets. As fast as banks led by Baring Brothers and N.M. Rothschild underwrote securities from Egypt, Uruguay, China and every corner of the globe, the trusts snapped them up. Recalled a witness in an article published around 1894, ” Firms of old standing vied one with the other in foisting unmarketable rubbish on the guileless investor.”

By 1889 nearly 50% of all British money invested abroad went into Argentina. But as corruption and inflation went wild, the Argentinean navy led a coup d’etat in late 1890, and Argentinean bonds sank from par in 1889 to 40 cents on the dollar by mid-1891. By 1893, 33 trusts that had raised £14.8 million (par value) from the public sold for just £4.8 million, a 68% collapse.

All of this may send shivers through anyone who had the misfortune to join in last year’s fund fad — emerging markets.

In 1993, 12 new mutual funds were opened to specialize in the stocks or bonds of less developed nations. They raised $1 billion eight times as much as the entire assets of this fund sector in 1990.

Unmarketable rubbish foisted on guileless investors? Maybe not, but latecomers to the fad took a hosing that was nearly as bad as that administered to British investors in Argentina a century ago.

After rocketing 119% last year, Hong Kong stocks fell 28% during the first half of 1994, while Israeli stocks, which rose 35% in 1993, flopped by 40%. Four equity funds specializing in China or Southeast Asia lost 20% or more.

Fad following is dangerous business. In the U.S. in the late 1920s, there appeared an irresistible passion to own closed-end investment companies. In 1928 alone 186 new funds rolled out, more than the total that had existed in 1926. Underwriters raked off as much as a tenth of the proceeds in fees.

The mania was fanned, as such manias usually are, by the media. The Magazine of Wall Street declared that rising prices for these issues were nothing to get excited about. In September 1929 it proclaimed: “To evaluate an investment trust common stock, preceded by bonds or preferred stock, a simple rule is to add 30% to 100%, or more, depending upon one’s estimate of the management’s worth, to the liquidating value of the investment company’s total assets.” Of 32 leveraged funds sampled by the Securities & Exchange Commission for 1929, 17 sold for a premium over net asset value.

Goldman, Sachs & Co. launched Goldman Sachs Trading Corp., a pyramid of closed-end funds each trading at a premium over net asset value. An eager public snapped up S326 million worth [2017 note: at least $4.5 billion in today’s dollars] by September 1929.

And then came the dreary dawn. By the end of 1932 Goldman Sachs Trading was worth $34 million and had become the butt of comedians’ jokes. The public was so disgusted that closed-end underwritings dried up for decades.

They burn people, but fads in investing keep coming. Atomic energy stocks, bowling stocks. Nifty Fifty, stocks with -tronics in the name. Each has blazed across the Wall Street sky, attracted the suckers and then crashed, burning them.

There are big fads and little fads.

In the early 1990s a mini-fad was leveraged muni funds. They goosed up their yields by borrowing short-term and lending long-term. Again, the public was dazzled and forgot the connection between share prices and net asset value. Dozens of leveraged muni funds came out at a premium to net assets. Investors lost billions in the bond market crash of 1994.

Option-income funds were all the rage in the mid-1980s. These funds juiced their yields by selling call options on bonds or stocks, then distributing the option premiums to shareholders as dividends. It was a great gimmick: By September 1987 these funds had raked in S8.3 billion. But they had to fail. When interest rates rose, options didn’t keep the bonds from falling in value, while if rates fell back, the option seller had given away the appreciation, and thus the chance to recoup earlier losses.

Current fads? REITs. In 1990 real estate was in a virtual depression, and only six sponsors had funds specializing in property-related stocks, with a measly $119 million in assets among them. But by 1993 real estate was hot: 141 REITs raised $18 billion from the public. Today at least 14 funds with $1.4 billion in assets specialize in real estate and REITs.

Investing overseas is still a hot fad, subject of chatter at cocktail parties and in cyberspace. There’s a strong case to be made for it, but this one, too, will go too far and end in big losses for latecomers.

What conclusion should the sensible investor draw?

Even the most complicated fund must live by investing’s simplest rule: Higher returns mean higher risk.

That goes for leverage, derivatives, yield enhancement and every other trick in fund marketing.

Beware a fund, or fund category, that purports to be new or unique. If it didn’t exist until recently, ask yourself why you are being invited in now.

Buying something that has just doubled, on the belief that it will keep on doubling, is an extremely bad idea.

Be wary of hot foreign markets. There are plenty of good U.S.-based companies whose products are household names abroad and which will profit handsomely as the poorer parts of the world get richer.

Never pay a premium for a closed-end fund. Never. In particular, never buy a brand new closed-end whose premium takes the form of an underwriting commission.

Don’t overpay for the skills of a supposedly great fund manager. Many differences in investment performance are due to chance. Warren Buffett? He defies the odds, but with a stock market valuation that is now double its breakup value, even his Berkshire Hathaway is too richly priced for our tastes.

In funds, as in any other kind of investment, figure out which way the crowd is headed and go somewhere else. Let the chatterers chatter about their hot “new” investments, ignore the puff pieces in the media and wait for the nemesis that stalks all fads. You can go the other way.